“Political Economy Problems” In the Analysis of Trade Policy Doug Nelson School of Economics.

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“Political Economy Problems” In the Analysis of Trade Policy Doug Nelson School of Economics

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Blinder’s Law Blinder’s Law: Economists have least influence on policy where they know most and are most agreed; they have the most influence on policy where they know the least and disagree most vehemently. Blinder’s main examples of the former are  Trade policy  Environmental policy.

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Consider Trade Policy Virtually all countries provide protection which is:  Non-uniform across sectors; and  Seems hard to rationalize in terms of any obvious economic welfare argument. In many sectors protection is sufficiently high that the net costs are positive, even large (e.g. agriculture, textiles, steel), but In some sectors protection is positive, but below estimates of the optimal tariff, so welfare could be raised by increasing protection.

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How do we explain this phenomenon? Politicians are ignorant Economists are ignorant Politicians are (possibly very) smart, but their goal is something other than pure social welfare maximization That is: Trade policy is a “political economy problem”

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On “Political Economy Problems” For most economists, this is a conversational trick meaning  The world isn’t behaving the way theory suggests it should, but  it isn’t our fault, so let’s pass over this unfortunate problem in silence. For a small, but growing group of economists this is the opening gambit in an attempt to extend the tools of economics to the domain of political and political economic analysis.

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What I want to do in this lecture Discuss the nature of the very real successes in the political economic analysis of trade policy; Discuss two “political economy problem” problems:  The “mystery of the missing protection”; and  The “normative political economy” problem.

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What is an Endogenous Policy Model? Basic Idea: Embed a simple model of political process in a well-specified model of the economy.  Use the economic structure to identify citizen preferences; and  Use the political model to map the preferences into outcomes.  These are essentially models of preference induced equilibrium.

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What Can You Do With An Endogenous Policy Model? Audit the logic of informal political economy analyses. Account for policy outcomes apparently inconsistent with “best practice” Provide a framework for positive and normative analysis.

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Endogenous tariff theory and policy preferences Derive the effect of a tariff via comparative static analysis for the small country case.  In general a tariff lowers aggregate welfare; however  With heterogeneity of factor-ownership or tastes across households, there are distributional effects (e.g. Stolper-Samuelson theorem); and  Tariff income is usually redistributed in a welfare neutral fashion.

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Endogenous tariff theory and a tariff referendum Now suppose that the tariff is chosen by referendum in which:  All households share the same preferences, and own 1 unit of labor, but own different quantities of capital  Preferences are single-peaked over the tariff; and  Individuals are non-strategic in their voting behavior.

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Endogenous tariff theory and a tariff referendum Black’s theorem states: if preferences are single- peaked over a one-dimensional issue, the most preferred point of the median voter cannot be defeated in a majority rule contest.  Hotelling-Downs theorem provides a mechanism for picking this outcome in 2-party competition.  Majority rule over a one-dimensional issue is an Arrovian democratic social welfare function.

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Endogenous tariff theory and a tariff referendum Mayer’s theorem states that in almost all cases the equilibrium policy will involve a non-zero tariff. NOTE:  The social welfare maximizing tariff is zero (by the small country assumption); but  The democratically optimal tariff is nonzero.

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Successes and Failures Successes of endogenous tariff theory:  Clear formalization of the “political economy problem”  Interesting cautionary tale The problem is non-trivial, i.e. the problem is not corruption here; rather The problem is an inconsistency between the democratically optimal and the welfare optimal trade policy. There are, of course, ways to make free trade democratically optimal (i.e. redistribution of income), but  We don’t observe much of this; and  If redistribution is chosen democratically along with trade, the dimensionality goes up with ugly consequences.

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Successes and Failures “Narrow” Failures  Additional theoretical effort on preference-induced equilibrium generates little additional content.  Empirical work on the political economy of trade policy is only loosely connected to the models “Broad” Failures  The Mystery of the Missing Protection These models are developed to explain bad policy, in this case protection; but the essential fact about modern trade policy is how liberal it is, not how protectionist.  Utter lack of compelling normative analysis.

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A quick word on narrow failures Political economy applications with more empirical success  Local public economics—school finance;  Macro political economy Better match between theory and data than in the trade case:  Actual referenda on trade extremely rare; and  Data and models on lobbying severely underdeveloped

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The Mystery of Missing Protection Over the last three decades there have been hundreds of papers and books on the the political economy of trade. The overwhelming majority have focussed on the political economy of protection or the failure of liberalization. This might lead us to suspect that protection is the most significant phenomenon facing us This is simply not the case.

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The Mystery of Missing Protection At least for industrial countries the single most striking fact of the last half century is the liberality of trade.  The average tariff has reached a historical low and shows no likelihood of increasing. Statutory tariffs are locked in by GATT/WTO commitments Standard data can’t show anything but liberalization Consider the US data

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At least for industrial countries the single most striking fact of the last half century is the liberality of trade.  The average tariff has reached a historical low and shows no likelihood of increasing. Statutory tariffs are locked in by GATT/WTO commitments Standard data can’t show anything but liberalization Consider the US data  Administered protection provides increase at the margin Empirical work finds it very hard to tap this protection. This is small potatoes compared to the magnitude of liberalization

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Explaining Liberalization: Fundamental Accounts Changed political fundamentals  Based on Key/Burnham theory of party systems Transition from System of ’96 to New Deal involved disappearance of trade as a political issue Hall/Kao/Nelson (1998) argue that female franchise is consistent with both the collapse of the System of ’96 and the disappearance of trade as a political issue.

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Explaining Liberalization: No General Theory of the Specific External Events  Both changed fundamentals stories are of this sort  Macroeconomic Crisis Leadership  Harberger: “A Handful of Heroes”  Institutional change and the need for leadership The unprotecting of liberalization in the US  End of the cold war  End of traditional Ways & Means Democrat v. Republican presidents:  Carter v. Reagan  Clinton v. Bush  Pro-Business should not be confused for Pro-market.  What do leaders do?

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Explaining Liberalization: No General Theory of the Specific Learning  Elite learning: interesting problem Clear transition in elite opinion on trade No one has studied how this occurred  Public learning Hall/Nelson (2002) show strong evidence of footloose public preferences on NAFTA; and Provide a simple theory based on information cascades. This approach provides leverage for informed policy advice (though it also supports all kinds of propaganda).

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The Normative Political Economy Problem This is where political-economy research on trade policy begins : Tullock and Krueger on rent-seeking; Bhagwati on DUP As political-economic welfare analysis, this is misguided  All lack a coherent welfare analysis of political activity  Some political activity is clearly corrupt and undermines democratic legitimacy, but much has the positive value of participation. A closely related problem is normative analysis without a politically plausible alternative  Consider the case of antidumping

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Back to Blinder Do economists really have no impact at all?  Is it just interests? (this is the implication of Blinder’s law and the fundamental basis of Chicago political- economy).  Blinder doesn’t think so, neither does Becker, neither does Paul Krugman.  The rest of us shouldn’t either So what should we be doing?

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Back to Blinder More Blinders, Beckers, and Krugmans  We need to be better engaged, explaining to real people, in language they can understand, why we believe that markets work.  Expecting most people to think like professional economists is just a mistake.  In my belief this extends to the structure and content of economics education at the principles level.

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Back to Blinder More honesty  Admit that getting the gains from trade means adjustment which is costly and falls asymmetrically.  If we are going to argue for liberalization we need either to argue for income transfers that support general gains and general political support; or explain why we don’t. Potential gains from trade arguments convince no one. More real political realism (not cheap cynicism)  This means more and better political economy  Which is where we started.